TMFPostOfTheDay (< 20)

How Do You Measure Goodwill?

6

I run a small business and I am thinking about Goodwill. I know I have it, I know I'm building it everyday but how do I measure it?

I love this question! Discussions like this keep me coming back.

[Especially in contrast to those endless discussions about BRK’s book value du jour, dividends, and even speculative discussions about potential publicly traded acquisition candidates – if we want to actually help Buffett, we should be making private Marmon/Iscar-type introductions, where owner/management does not have a fiduciary obligations to maximize price, but can conduct sales in complete privacy – and where Buffett's competitive advantage can work its magic in obtaining pricing discounts vs public markets, instead of that typical 20% premium for public acquisitions.] Excuse me.

This question, however, really made me try to condense my thinking about Goodwill.

If we were to ask your question of three professionals - the accountant, the financial analyst, and the marketing professor - we'd likely get three different answers. Individually, their answers might be incomplete for your very practical purposes, but taken together we can perhaps get a framework for value.

Here is a snippet of what a marketing professor just recently wrote, as a classic marketing example: “..ask what would happen to Coca Cola’s ability to raise financing and launch operations anew if all its physical assets around the world were to mysteriously go up in flames one night.” Then for comparison he poses the hypothetical “..if,instead, 7 billion consumers were to wake up one morning with partial amnesia, such that they could not remember the brand name Coca-Cola or any of its association..” While he isn't giving us a goodwill formula, he is at least helping us get comfortable that intangible value exists, and of is significant. Let's move on.

Your CPA will tell you that ‘goodwill’ is a defined accounting term, and we calculate it strictly from the balance sheet by way of what they call ‘purchase accounting’. It’s really just the accounting profession’s big ‘plug'.

When we buy a company, accountants look at the balance sheet and bring all the values, assets and liabilities, up to current market values – your coolers and other fixtures, inventories, payables, etc. They look at the updated net number of all those pieces, and they compare that to the actual price paid. To the extent the purchase price exceeds the recalculated numbers, accountants call the difference ‘goodwill’. They put that backed-into plug on the balance sheet.

Pundits look at that balance sheet number suspiciously (it inherently assumes the price paid was appropriate), but bad deals aside, if we think about what we ourselves would pay for Coke or See’s above their hard asset market value, we understand the mark-up. This still doesn’t help you come up with a useful calculation (yet) but let’s file that thought.

Financial analysts, on the third hand, look at what they consider ’goodwill’ from the P&L perspective, ignoring the balance sheet. If they see higher earnings than you ought to be getting from your investment – better than the typical florist - they take those excess earnings and apply a capitalization factor (4x, 10x, whatever) and come up with the number those excess earnings are worth – the premium a buyer should be willing to pay for your superior company, with its apparent goodwill.

We actually have industry performance data on small florists, by the way, and we can see how you stack up. This isn’t the complete answer for your purposes, either, but it’s also a stepping stone to getting there.

Let’s see if we can come up with some methodology using all of those thoughts, though.

You know what you have invested in your business, and you probably have a good idea of what those assets you bought are currently worth. You also know your revenue, and (hopefully) what your cash flow looks like.

First, with our financial analyst visors on, we can look at current industry average data for florists. We can see how you stack up. To the extent that your goodwill-producing activities kick in and we start seeing these reflected in results – outperforming the averages - your cash-flow out-performance can be quantified. We can capitalize that excess using known market multiples for small florists. We'll come back to that.

Now switching to accounting hats. I happen to subscribe to a data-base of private sales transactions, including sales of very small businesses like yours. The database lists well over 100 florist business sales, with such interesting tid-bits listing price, days on market, actual sales price, revenues, earnings, financing if known, and location (or at least the state). We can think of this as the market price data for small florists.

With this data we can work from the other direction – looking at actual transactions, adjusting for your business’ characteristics (perhaps a big plus for demographics, a minus for seasonality), and getting a ballpark as to what your business might be worth. This data is also helpful for getting price multiples. PE’s might be less reliable (as you can understand for your own business) than in the public markets, but actual market multiples of factors like revenues and book value can be useful for getting a ballpark value.

Once you get some idea of market value and the market multiples, you can at least get a general idea of how increases in cash flow and revenues translate into the market value of your business. By looking at ‘excesses’ from both perspectives - the excess of a current approximate market value over own investment, plus a 'capitalized value' excess any earnings your business may be generating versus your peers (using actual florist earnings multiples per those 100+ transactions) you can start to measure that intangible goodwill you are hopefully building.

Re-reading this, it sounds more complicated than it is. Just remember to keep an eye on your business's results versus those that have sold, and from the other perspective your earnings versus industry averages (the different of which you can apply price multiples to.

I can’t post all that data here, and in any case it will take me some time to get into a usable format, but if I remember I will send that off-line, maybe right after the holidays.

I will caution however, and I know I don't have to say this to you, but newcomers to the small private business world and often surprised at how low the multiples actually are.